The European Central Bank (ECB) could string out its Quantitative Easing (QE) programme for longer than markets expect in order to specifically target the rising Euro.
The suggestion is put forward in a UBS thought-leader note penned by Beat Siegenthaler, a Global Macro Advisor with UBS in Switzerland.
"Can the ECB dampen euro strength? Will it even try? Initially Thursday’s meeting was expected to be all about QE next year. Not anymore. Instead, the focus will be on the exchange rate, at least as far as the market is concerned," says Siegenthaler.
Markets expect the ECB to announce a gradual reduction in its monthly asset purchases at the next meeting on Thursday, September 7, but there is a heightened chance the call will be delayed until October when Siegenthaler expects the ECB to announce a reduction to €40bn a month in purchases (from the current €60bn).
The reason for the delay for the announcement is the strong Euro which is likely to have a dampening effect on inflation in the new year ensuring the ECB's fails in its mandate of pushing CPI up to the target at 2.0%.
"What impact will the Euro have on Thursday’s inflation projection? The 2019 forecast will likely drop to 1.5% or even 1.4%, down from an already low 1.6% back in June. In fact, the UBS interactive inflation model suggests that at current Euro and oil levels, CPI inflation could drop to as low as 0.6% in Q1 2018," says the author.
Even if there are those in the ECB who might argue that better-than-expected economic data would offset some of the energy and Euro impact on inflation, the doves will likely use the forecast as a strong argument for extending QE.
This would likely halt the Euro's recent rise, leading to consolidation or retracement against the likes of the Pound and US Dollar.
If the ECB backpedals on cutting stimulus, Siegenthaler believes the Euro is likely to remain below the 1.20 EUR/USD August spike highs.
UBS's official expectations are for a cut to €40bn month purchases at the 26 October meeting, decision and then a further taper to €20bn in March 2018, "before the eventual culmination of QE in Jun-Sep, equating to an additional aggregate purchase of EUR 180-210bn," says Siegenthaler.
ECB to Try and Talk the Euro Down
Action on bonds would be the most effective way of dealing with a strengthening Euro which has been rising through 2017 in expectation of the ECB announcing a withdrawl of stimulus.
But, directly talking the Euro down is another option that might impact on the Euro.
In relation to what might be said at the actual meeting on Thursday, Siegenthaler thinks that the strong Euro may be mentioned in the ECB's official statement as a reason for downgrading inflation, and this will be re-emphasised by Draghi in his Q&A.
But, talk is unlikely to have a lasting impact as the Euro is still well supported on a fundamental basis, "with positioning in European assets still catching up with much-improved investor sentiment," according to Siegenthaler.
He also sees potential uplift for the currency after the German elections, assuming they further enhance European Unity as opposed to fragmentation.
"EURUSD was trading at around 1.30 before the ECB launched its asset purchase program. The trouble for the ECB could be that should the market continue to push up the Euro, the anticipated end to QE might have to be postponed beyond 2018. Since this would be reactive rather than proactive, the market may nevertheless remain unimpressed and thus compound the headaches for the ECB," says Siegenthaler.
The suggestion that the Euro is going higher regardless of the ECB has been echoed across the analyst community.
To be clear, we don’t expect the ECB to deliver an effective protest against Euro appreciation... the Euro is appreciating for the right reasons and so while any attempt to talk down the currency would doubtless be effective in the short run it is highly questionable whether this would abort the longer-term EUR uptrend,” says Daniel Hui, a foreign exchange strategist at J.P. Morgan.
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